Hello, and welcome back to Unlocking Markets, the RBC Global Asset Management podcast where we bring you experts from across our firm, providing opinions on markets, global policy, sustainability, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, Head of Global Financial Institutions. Today I'm delighted to welcome Habib Subjally, head of our Global Equities team.

Global equities have faced considerable challenges over the past five years, including a global pandemic, the outbreak of war in Europe, inflation levels that have not been witnessed for nearly 50 years, and then the most rapid increase in interest rates that most investors have experienced in their careers. But despite these events, global equity markets have continued to climb. So, I'm hoping Habib can give us some insights into what is driving this momentum. Habib, welcome to the podcast.

Hi, Mike. Thanks for having me on.

Great to have you here. Looking at what's been going on and despite events that many would think would derail equity markets, they continue to perform well. What factors are driving this strength, and do you think it can continue?

It's interesting the way you asked the question, Mike, because you mentioned a couple of crises there; pandemic, inflation, and so on. Of course, these are big issues now. I'm going to frame my answer in two parts.

One is the macro answer, the pandemic, we had great fiscal, and monetary support. The authorities certainly helped markets, and that was very kind. With inflation, obviously the opposite. There's been rising interest rates, and that has not been kind to markets.

Then I think it's also interesting that over the five years, you point to the crises that have happened, and suggest that this has been a tough time for equity markets. But I would also point out that this has been the time when you've had enormous industrialisation of the internet. You've had the move to cloud computing. You've had e-commerce hitting this enormous scale. We all were working from our homes under lockdown, and yet we moved from our corporate networks to public networks. We had food and shopping delivered to our homes; entertainment, streaming TV rose to the occasion. You've had renewable power, LNG, immunotherapy, other medical device train developments. Now you've got GLP-1s, these weight loss drugs. You've got artificial intelligence. There's been an enormous amount of productivity, innovation. These have been great things. People obviously when they look back, they point to these negative events, but at the same time, there have been all of these very positive, powerful value-creating drivers that have been taking place in equity markets.

Great. Behind it, there's been a lot of transformation, themes that are away from maybe some of these headlines. Coming across it a little bit more in a bit more depth though, I'd say that global equity markets have remained broadly strong, but it's very clear that there's a dispersion between the US and the rest of the world. Even within the US market itself, many commentators have highlighted that the rally has really been driven by a very limited group of stocks and the ‘Magnificent 7’, as they're known. Do you believe this is justified? You, as a portfolio manager, how does this impact your stock selection?

I think we've seen periods like this before in financial markets. When you've been around as long as I have, you remember, well, don't remember, I certainly studied the NIFTY 50 and certainly I remember the dot-com bubble. Markets do get quite concentrated, but in this case, I think there is some justification. These are businesses, they are great businesses that have the opportunity to transform the way we live, the way we work, the way we communicate, the way we entertain ourselves, and can drive great productivity.

I think you can understand why that has taken place. I think it's also important to say that many of these companies, almost all of them are domiciled in the US, and that says something about the US in terms of their entrepreneurialism, their innovation, and their ability to fund and nurture these businesses. But it's not exclusively the US. There's a very strong semiconductor supply chain in countries like Taiwan and Korea. When you get out of technology and look at healthcare, GLP-1s, yes, there's a US company that is pushing them and selling them, but also a Danish company, a European company.

I think this is more about just great companies that are creating an enormous amount of value. It is fair to say many of them are domiciled in the US, but I don't take that as a US-specific thing. I think that's where great companies can be nurtured and developed.

In terms of, as an investor, how we think about stock selection here, I think it is very important that we are picking stocks, rather than making a bet on the ‘Magnificent 7’ on or off. So, the way we think about it, there's a portfolio construction challenge. We are, today, we own four of the seven. We've been very deliberate about choosing which ones. That is very stock selection. We are also very conscious we don't want to be significantly overweight the ‘Magnificent 7’, because we know there are a lot of investors who are playing this as a theme and there are ETFs and so on, and you can get caught in those things, in that flow, which can be very powerful.

Also, we have to worry about valuation. Having invested for as long as I have, we know that these great companies get driven up in value because people have a failure of imagination as to what these new technologies can do and achieve and how pervasive they can be. At the same time, at some point, valuation and expectations catch up and exceed the reality. You go back 20 years, when we talked about the telecom revolution and the internet and so on, there was a huge bubble there. I have to say, everything that those companies talked about in the late 90s has come to pass and has been exceeded, but that didn't stop us having a big fall in value. When that dot-com bubble burst in the early 2000s, it took a long time to recover that value. Again, this is something we have to be very conscious of: valuation. It's portfolio construction, valuation, but ultimately, it comes down to, do you identify these great wealth-creating businesses.

That's great. You've got the trade-off there between actual – how industries are expanding, and it's interesting to highlight the '90s. I remember back in the '90s into the 2000s, that huge crash. You're right, so much has happened and come through. It's just buying things at the right price, at the right time. One of the big themes that has come through and has underpinned some of the ‘Magnificent 7’ is artificial intelligence, and everyone's been talking about it a huge amount in the past 12 months. But away from the well-documented leaders in this sector, are there other parts of the supply chain that you think will be beneficiaries of this boom? Not name-specific, but sectors, areas?

Right now, what's really captured the imagination of technologists and investors has been the ‘picks and shovels’, right? It's been the hardware guys, the guys who supply the GPUs, the memory, the data centres, and the hyperscalers where all of these models are being trained. There's this enormous arms race going on, who's going to have the best model and the most pervasive model, and so on. There's a lot of hype around there. You can see, each model that is being generated is better than the last one. We can see the potential for this technology.

For all of this to be worth it, this has to start impacting consumers, both consumers in their personal lives, as well as consumers or users in a corporate setting. It has got to be able to make our lives better, give us better productivity, create more value for us, for our customers, and for ourselves. I think this is crucial. Until we see this, this is an enormous investment in the picks and shovels, the infrastructure, and the models. It has to have value at the top of the funnel for users and consumers. This is going to happen in every field, whether it's medicine, it's entertainment, making movies and advertisements, to accounting and completing your tax return, to legal advice, to diagnosis of radiology reports, to the way we shop. It's going to impact every business. There are going to be winners and losers. Those companies that can harness this technology for their own stakeholders, whether that's their consumers, their customers, their employees, and drive productivity and value will be the winners and those that lag behind will be losers.

That's why you can see so many companies in so many industries racing to get ahead. There's going to be a lot of wasted effort and energy, but this could well be existential. If you think back to the late '90s when the internet first came along, and you had these e-commerce retailers come along and you had the bricks-and-mortar guy saying, "Ah, the internet will never catch on. It's never going to impact our business. Who's going to buy clothes and shoes and stuff like that on the internet? Consumer electronics on the internet? No. No one will ever do that." Well, look what happened. I think that learning is now running across all these different industries where they're saying this new disruptive technology is coming along and that we have to win with this, otherwise, someone else is going to disrupt us.

Yes, you're right. It's incredibly disruptive in terms of technology. Businesses trying to work out how to implement that is going to be so important. There are going to be some real winners and there are going to be some losers.

Stepping away now and looking at you again, this is more as a global investor, you have the luxury of having no geographical constraints and regional economics can have a major impact on the profitability of companies, as we know. One in particular close to my own heart is Japan. After four decades of slumber, it appears to have re-awoken and is once again attracting investors from across the globe. Are you finding some interesting value in the Japanese equity market, or do you still find more attractive opportunities in the rest of Asia generally?

Japan is a very interesting market to look at because, as you say, for the last 30-40 years, it was very easy to ignore for both macro and micro reasons. Macro reasons: deflation, negative interest rates, a very tough place to be. Now, for the first time, you do have inflation, but Japan has always been a very cyclical market, so it's very hard to see now if economic growth in the world slows a bit with rising interest rates, does inflation start falling again in Japan? Also, you've got this demographic profile of Japan. It is an ageing economy, but a very tight labour market. Again, the macro is balanced in our view, but that's what most people have been getting excited about.

For us, the way we look at Japan, Japan has always had some great, great businesses in industrial technology, even some consumer areas. Those businesses have been run for their customers and their employees. The governance reforms that Shinzo Abe started pushing a number of years ago are slowly coming through, and you're seeing this re-awakening, the phrase you used. To me, I think it is this recognition of shareholder value. The Tokyo Stock Exchange sort of names and shames companies based on the return of invested capital and so on. This is a change in governance in Japan. This has the potential to unlock what were some really great businesses in Japan for the benefit of shareholders. Certainly, yes, we are spending a lot of time looking at Japan.

I believe a number of other people are as well. I hope you find some value there. As I say, it's a market that's very close to my own heart, having started my career in the Japanese market, as you say, a couple of decades ago, shall we say.

I had the pleasure recently of seeing you present your team's approach. I saw that one of the things that you really look at is the way you look at analysing intangible or non-financial data and how that adds value. I know these can include factors such as corporate culture, employee and customer satisfaction, and also how engaged senior corporate officers are in the importance of ESG. I would really like to hear, maybe share with the listeners, how you and your team attribute economic value to these non-financial factors and how you actually believe they can improve overall investment returns.

Mike, this is a great question. Our job in the equity market is to identify these great wealth-creating businesses and get them into the portfolio. It's very simple in concept because these great businesses do take capital and they multiply it over years. This is what, essentially, we're trying to achieve. Now, if you ask most portfolio managers, analysts and market participants what makes a great wealth-creating business, what makes a great investment, typically the answer you get back is a series of financial ratios. Like high EPS growth at a low P/E or high CFROI, return invested capital at a low price to book, and stuff like that.

For about 35 years now, I've been asking successful entrepreneurs why their business is a great business. Never once did I get an answer back that had anything to do with a financial ratio. It was always to do with, "It's our people, it's our business model, we do things differently around here" "We innovate cheaper, better, faster than our competitors" or, "We have a culture of delighting our customers and our customers then become our salespeople. This is why we have this great brand and reputation" and so on.

These are the things we think define a great business. It is the way a business interacts with its employees, the way the business interacts with its customers, its suppliers, its community, its environment, the way it innovates, the way it deals with regulators and how it builds its reputation. That drives great commercial success, which drives great financial success, which drives great share price performance. We want to identify these extra financial factors before it becomes apparent in the financial returns. The financial returns are an outcome of these extra financial factors.

Sorry, this is a rather long-winded way of getting to it. The framework we've developed for the last 18 years on our team is what we call contingent liabilities and contingent assets. Think of it this way -if you're a US CEO, you have a career expectancy of about four years, and that's an average, right? That is made up of Jamie Dimon, people like that who have been there a long, long time. As a US CEO, it's typically a ‘he’, he is expected to probably make something like $20 million in his first year. His salary is about $1 million/$1.5 million. The rest is an options package. This CEO is solely focused on maximising the value of that options package. It is worth a lot of money to him. If he can survive the first year, bank that $20 million, there's another $20 million on the table for him. He would typically do anything to make and exceed the quarterly earnings forecasts that have been set out for the company.

Businesses don't work in straight lines, they have wobbles along the way. There's volatility in life. What CEOs tend to do is they tend to borrow from extra financial sources of capital to create short-term profits. Think of it this way. The easiest thing a CEO can do is to slash research and development. If he cuts research and development by $100 million, that goes straight to the bottom line. Profits go up. Not only do profits go up, margins look better, cashflows look better, return on invested capital looks better. If you look at this business purely from a financial lens, you say, "What a great CEO. He's improved the business so much."

When we look at this from an extra-financial lens, we say "All he's done is borrow from the future." That borrowing has a very high interest rate associated with it because sooner or later his customers are going to realise that "I'm not getting any innovation. Competitor products are better." Soon they're going to find another supplier. This is a value-destructive strategy in the long term.

Similarly, you see CEOs borrowing from their customers by cutting customer service levels, by reducing the quality of their staff, by borrowing from their employees, by cutting training and development budgets, by borrowing from their suppliers, by demanding unreasonable payment terms and discounts, by borrowing from their communities, by mis-selling, mis-advertising, anti-social business practices, and borrowing from the environment by cutting safety and maintenance budgets.

Now, there are businesses that also invest in these contingent assets, by investing in their people, their customers, their supplies, and R&D, in safety, maintenance in their environment, and this creates contingent assets. Now, the thing is that contingent liabilities flatter short-term profits. Investing in contingent assets means that short-term profits are slightly lower than they would otherwise be. These businesses that create contingent assets will be sustained over the next 5, 10, 15 years by these contingent assets. This is the market inefficiency that we exploit.

The market treats a dollar of profit the same, regardless of whether it comes from creation of contingent liabilities or after investing in contingent assets. For us, we want to avoid investing in businesses with large contingent liabilities and only invest in businesses with contingent assets.

That's great. Just understanding because everyone's trying to look for an edge, and all investors are trying to work out how they add extra value. The numbers out there are available to everybody. To me, looking at thinking of a way that you can actually find real value that's not on a balance sheet is a very interesting way to approach overall investing. I can see how you can add value in that way.

Thanks, Habib. It's really great to get your perspective on global equities. You and your team have such deep knowledge across a really broad range of countries and that just comes through. It was fantastic to get your insights. On the plus side, I didn't argue to predict the result of the US presidential election once – a ‘Get Out of Jail Free’ card there because everybody else gets asked that. Thanks, Habib.

Thanks very much for having me on.

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